Main navigation

How am I investing in commercial real-estate?

RealtyShare, a crowdfunded real-estate investing operation, just shut down its business a few weeks ago. Hopefully, everyone who invested through them will be fine. The company said they will keep skeleton staff to manage existing properties for investors but won’t offer any new real-estate deals.

RealtyShare was a relatively recent venture — it started five years ago. It was among a new breed of Internet based real-estate operations that raise capital from small non-accredited investors. There are others like that.

In April this year, I wrote a blog post, My quest for commercial real-estate, where I briefly mentioned RealtyShare. At the time I was looking into commercial real-estate investing opportunities but I didn’t want to invest in these crowd-funded startups with unproven track records. Instead, I looked into Blackstone’s non-traded REIT that was open to individual investors. As I explained in that post, I didn’t invest in BREIT, but I did end up buying other REITs and Blackstone, the company itself.

The demise of RealtyShare raises some interesting questions. Why do investors fall for newfangled investments while ignoring well established long tenured operations? Specifically for investors seeking commercial real-estate, why do so many prefer private real-estate opportunities over publicly traded REITs? Are private real-estate less volatile than the publicly traded kind? Let’s look into each of these questions …

Why are individual investors attracted to small-scale investments? I see this first hand all the time. Among friends, neighbors, community members, interest groups. People who tend to save are naturally looking to invest their money someplace. Most understand the perils of keeping their savings entirely in cash. But they are also wary of investing in the stock market, so they seek alternate investments. Investments such as real-estate (both residential and commercial), precious metals (gold and silver, mostly), partnerships in small businesses, etc. Today, given the state of the economy and generally favorable investing environment, small investors are feeling confident enough to put their money to work.

Over last two years, I have seen many alternate investments pitched to my friends and acquaintances. From solar farms to rental properties to car rental business and bitcoin mining operations. They all tend to have two common threads. One, they offer “excellent”, “nearly guaranteed” (with a wink and a nod) returns — often no less than 20% annualized. Second, these investments are always pitched by a friendly familiar face — someone who belongs to the same community or the church group.

A vast majority of these investments are not outright scams or frauds. However, they often fall well short of expectations — not providing good returns and also not returning investors’ capital in a timely manner.

What investors don’t realize is that they are taking much greater risk of permanent capital loss when investing with small private operations — versus investing in some large public company. Usually a small private operation is formed as an LLC (Limited Liability Company) with limited capital backing it. If things go sour for any reason, an investor wouldn’t have much legal recourse against the operation. Public companies, on the other hand, have far more oversight and stricter regulations to follow — from independent board members to accounting standards and disclosure requirements. And if we choose companies with long tenure and good historical performance, risk of capital loss is lower.

Why is it that folks are often willing to invest in small speculative ventures but shy away from stocks? I am sure there are more than one reasons for this. A few things that I’ve observed: People tend to put more trust in someone from their own background (or interest group) who pitches a business idea. People also like to follow others — there’s safety in herd behavior. If their friends are investing in a business, they tend to feel more secure about putting their own capital too. And finally, a lot of people fail to associate stocks with real underlying businesses. Instead, they see them as mere numbers that move around.

Returning to our real-estate investing context here, we could ask ourselves a similar question: Why do individual investors look for direct real-estate opportunities but stay away from investing in REITs? I believe the reasons are more or less the same that we discussed earlier. The lure of “guaranteed” higher returns and the sense of owning a real asset as opposed to some stock symbol that fluctuates in value every day. Investors love high returns but we also prefer steady consistent returns.

But REITs are real-estate investments too. And nothing in the investing world is ever “guaranteed”. Still it is true that some (public) REITs that are listed on stock exchange fluctuate in price every day. And some investors associate them with common stocks and think they are far too volatile for them to own. David Swensen, Yale’s well-known endowment manager, wrote about this in his book, Pioneering Portfolio Management.

The higher volatility of REITs, along with a significant correlation to small-cap stocks, cause many investors to conclude that REITs share more characteristics with common stocks than with real-estate.

He then went on to say this:

… in the final analysis, REITs represent real-estate

Other REITs that are not traded on an exchange do not get repriced on daily or even weekly basis. For instance, the Blackstone REIT. BREIT’s underlying assets are appraised once a month by an independent third-party. So investors get one valuation a month. They also get just one opportunity every month to buy or sell at that price.

Enter Public REITs: A publicly traded REIT that I own in my portfolio, Simon Property Group (SPG), is traded every day like other stocks. [I made my case for investing in Simon here.] I could trade it multiple times a day if I so desire. Instead of getting appraised once a month, it is repriced by other shareholders every day. And therein lies an issue. Because it trades like other stocks, its daily value is often affected more by the prevailing mood of the stock market than its underlying assets. But I choose to ignore these fluctuations. After all, I don’t check market value of my home on Zillow every day. I am not interested in selling it regardless of the price I am offered. If I were invested in a non-traded REIT, I’d not get a daily appraisal either. Just the same way, I choose to ignore these daily price changes in my public REIT positions as well. For long-term investors, checking stock prices every day does no good.

As I explained in that blog post, I ended up not investing in the BREIT because it wasn’t accessible from discount brokerage accounts. I liked its prospects though. It was being managed by one of the leading real-estate investing firm, Blackstone. And it was investing in a diverse portfolio that included all types of commercial real estate — office buildings, multi-unit residential, hotels, warehouses, retail centers, etc. I had a place for it in my portfolio but just not at the price it was offered at.

It goes without saying that I don’t have access to institutional-quality private real-estate investments — be they in form of private REITs or private-equity managed funds. So, I rely entirely on publicly traded REITs for real-estate. I don’t mind that these REITs look riskier because their prices fluctuate with common stocks. I treat them like any other real-estate investment. I focus on the actual properties they own and cash-flow they generate and return to shareholders.

I also own shares in Blackstone (BX), the world’s largest private equity manager that runs BREIT. Blackstone is also one of world’s largest real-estate investor. Year to date, nearly 36% of its income came from real-estate operations ($1.01 billion out of $2.79 billion). Its real-estate portfolio is worth $120 billion today. It includes all kinds of real-estate properties located worldwide. My ownership of Blackstone shares gives me a sizable share of diverse real-estate exposure – though technically Blackstone is not a REIT.

This table shows my current REIT positions and how they’ve done so far. I continue to add to my real-estate portfolio opportunistically. In last one year, I have been a buyer of Blackstone and Simon Property shares. You can see from the table that both the positions are relatively recent — less than two-year old. The other two positions, American Towers and Retail Opportunity, are much older stakes. They’ve had a good run up in last few years — you can see it from my unrealized capital gains on them.

Today, my REIT holdings are generating about 5.5% yearly dividends. My positions have also increased in value by 18% in last three years. Combining dividends with valuation gains, so far I have generated about 10% annualized return. This is not too shabby given that these are real-estate investments after all. Though I don’t focus much on valuation gains as they are subject to stock market foibles. I like that 5.5% current income though and it is set to rise every year as each of these REITs have good growth runways ahead of them. Also keep in mind that it is still a relatively young portfolio with an average holding duration of just three years (in dollar weighted terms). I plan to hold these positions and over time add to them.

A final thought. I am not suggesting that publicly traded REITs are the only way to invest in real-estate. Some investors may have access to privately held REITs (or private investment clubs) where individual investors pool capital and invest in large private deals. And that would be a fine way to play commercial real-estate too. Channeling David Swensen once again:

Regardless of the idea of the moment, long-term investors favor REITs when portfolios trade at a discount to private market values, avoiding high-priced private assets, and sell REITs when shares trade at a premium, pursuing relatively attractive private properties.

Makes perfect sense to me. Though, I am sticking to public REITs for now until I see a safe long-term opportunity to invest in private deals.